General Tax Due Diligence Questions

The following due diligence questions track the language of I.R.C. 144(b), which sets forth the requirements for qualified student loan bonds.

__ Is the “applicable percentage” or more of the net proceeds used to finance “student loans”?

Applicable percentage for purposes of the HEA Program referred to below is 90%. For the alternative program referred to below, the applicable percentage is 95%.

A student loan is treated as made or financed only if the student is (1) a resident of the State from which the volume cap under I.R.C. 146 for such loan was derived or (2) enrolled at an educational institution located in such State.

Are the student loans financed under either:

__ A program of general application to which the Higher Education Act of 1965 applies (a “HEA Program”) (not currently available); or

__ An “alternative” program, satisfying the following requirements:

Program of general application approved by the State;

No loan under the program may exceed the difference between the “total cost of attendance” and other forms of student assistance for which the student borrower may be eligible (see Notice 2015-78); and

The program is not an HEA Program.

__ The issue of which the bond is a part must not meet the private business tests of I.R.C. 141(b)(1) and (2) (determined by treating 501(c)(3) organizations as governmental units with respect to their activities that do not constitute unrelated trades or businesses, determined by applying I.R.C. 513(a)).

__ If the issuer is a nonprofit corporation, the bonds must constitute “Qualified Scholarship Funding Bonds.” I.R.C. 150(d). Bonds are QSFBs if they are issued by a corporation that is (1) a not-for-profit corporation established and operated exclusively for the purpose of acquiring student loans incurred under HEA and (2) is organized at the request of a state or political subdivision of the state. The corporation should be required by its organizational documents or by state law to devote any income to the purchase of additional student loans or to pay over its income to the United States. The corporation must be operated exclusively for acquiring student loans. A corporation that is a servicer is not operated exclusively and is not an eligible issuer. PLR 9407016. However, a corporation is permitted to provide loan-servicing services. PLR 9126019.

Private Business Tests

I.R.C. 144(b)(1), flush language, provides that a bond will not be a qualified student loan bond if the issue of which such bond is a part meets the private business tests of paragraphs (1) and (2) of I.R.C. 141(b) (determined by treating 501(c)(3) organizations as governmental units with respect to activities that do not constitute unrelated trades or businesses, determined by applying I.R.C. 513(a)). This paragraph was added by the 1988 Act. When would this come up? It might come up where the student loan issuer loans the money to a company (a trade or business) – but that would violate other provisions of the Code. It probably arose from certain savings and loan arrangements where an issuer would loan the moneys to a savings and loan organization, which would then make loans to students. Since the moneys were deposited with the savings and loan organization, federal guarantees for the deposits provided “free” security for the bond proceeds.

Loans under the Higher Education Act of 1965

The Higher Education Act of 1965 authorized the Federal Family Education Loan Program (FFELP). FFELP was the second largest of the United States education loan programs and was funded through a public/private partnership administered at the state and local level. Following the passage of the Health Care and Education Reconciliation Act of 2010, the program was eliminated and no subsequent loans were permitted to be made under FFELP after June 30, 2010.

Temporary Periods

Proceeds of an issue that are used to finance student loans under I.R.C. 144(b)(1)(A) may be invested without regard to yield restriction for an initial temporary period equal to 6 months. Module H of IRS Training Manual. See also I.R.C. 148(c)(2)(A) (Providing that temporary period may not exceed 6 months with respect to proceeds of an issue which are to be used to make or finance loans (other than nonpurpose investments) to two or more persons.) There is a special rule for bonds issued prior to January 1, 1989. [The IRS Training Manual probably means to say that the 6-month temporary period applies to private loans under I.R.C. 144(b)(1)(B), too.] Any “proceeds” received as a result of a repayment of a loan may be invested without regard to yield restriction for a temporary period equal to 3 months. See I.R.C. 148(c)(2)(B) and Treas. Reg. 1.148-2(e)(4)(ii). Yield reduction payments are not available in connection with I.R.C. § 144(b)(1)(B) loans.

Allocation of Gross Proceeds to Loans

Treas. Reg. § 1.148-6(a)(1) states that an issuer may use any reasonable, consistently applied accounting method to account for gross proceeds, investments and expenditures of an issue. Under Treas. Reg. § 1.148-6(d)(2) (allocations for purpose investments), gross proceeds of an issue that are invested in purpose investments are allocated to an expenditure on the date on which the conduit borrower under the purpose investment allocates the gross proceeds to an expenditure – not when the issuer makes the purpose loan. However, under that same subsection, if the gross proceeds are allocated to purpose investments that are a qualified mortgage loan or a qualified student loan, the gross proceeds are allocated to an expenditure on the date on which the issuer allocates the gross proceeds to that purpose investment. In either case under Treas. Reg. § 1.148-6(d)(2) (allocations for purpose investments), those gross proceeds stay allocated to the purpose investment until the purpose investment is sold, discharged or otherwise disposed of. (The Internal Revenue Service has claimed that “other disposition” does not include the sale of a loan from one trust to another trust.)

“subpart 1 of part A” of this subchapter (as determined in accordance with section 1091(b) of this title): Relates to Federal Pell Grants, academic competitiveness grants

“subpart 3 of part A” of this subchapter: Relates to federal supplemental educational opportunity grants

“part C of subchapter I of chapter 34 of title 42”: Relates to federal work-study programs

“part D” of this subchapter: Federal Perkins Loans

plus other scholarship, grant, or loan assistance, but excluding—

any national service education award or post-service benefit under title I of the National and Community Service Act of 1990 [42 U.S.C. 12511 et seq.]; and

any veterans’ education benefits as defined in section 1087vv(c) of this title; and

Other Matters

Payments made by the Secretary of Education pursuant to section 438 of the HEA of 1965 are not taken into account, for purposes of 148(a)(1) (acquiring higher yielding investments), in determining yields on student loan notes. See I.R.C. 148(g).

The purchase of student loans is probably a capital and not a working capital expenditure, according to FSA 001678 (Jan. 31, 2004).

Creation by student loan entity of a secondary market in guaranteed student loans advances the 501(c)(3) charitable purpose of lessening the burdens of government. Purchase of loans with debt does not convert the loans into an unrelated trade or business. FSA 001678 (Jan. 31, 2004).

PLR 201126020, July 1, 2011: Ruling to the effect that the issuer’s proposed actions to cease status as a qualified scholarship funding corporation under section 150(d)(2) will not cause the interest on the bonds to fail to be excludable from gross income under section 103. (HHNNAAA) See also, PLR 201528035, regarding the same issue.

PLR 201447023 (August 1, 2014): Bonds issued to refinance 144(b)(1)(B) student loans satisfy the nexus requirement and can be used to refinance capitalized and accrued interest on the original loans.

Other Basic Definitions

Pell Grants: A Pell Grant, unlike a student loan, does not need to be repaid. The maximum yearly grant amount is $5,500. The grant is generally only available to undergraduate students and for not more than 12 semesters. The amount of a grant award depends on financial need, the cost of attendance, status as full-time or part-time student and plans to attend school for a full year or less than a full year. NFP Program: “Not-for-profit servicer program” – A not-for-profit servicer is an “eligible” and “qualified” entity for Title IV student financial aid servicing, in accordance with Section 2212 of the Health Care and Education Reconciliation Act of 2010 (Pub.L. 111-152, 124 Stat. 1029). CFPB: Consumer Financial Protection Bureau, an instrumentality of the government with oversight responsibility for student loans. Recycling and recycling period: Recycling is the use of revenues to make new eligible loans. Recycling is typically permitted during a specified period during which revenues do not need to be used to make redemption payments on the bonds. The length of recycling periods is set, in part, by credit needs. Origination period: Period during which the issuer may use original proceeds of the bonds to finance eligible loans. The origination period may typically be extended.

General Overview:

Issue price is key to determining the bond yield for tax purposes, which has a bearing on whether the issuer of tax-exempt bonds is meeting arbitrage requirements or whether an issuer of a taxable build America bond is receiving an appropriately sized federal subsidy payment.

Treas. Reg. § 1.148-1(b) defines “issue price” as “defined in sections 1273 and 1274. Generally, the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is sold to the public. Ten percent is a substantial amount. The public does not include bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters or wholesalers. The issue price does not change if part of the issue is later sold at a different price. The issue price of bonds that are not substantially identical is determined separately. The issue price of bonds for which a bona fide public offering is made is determined as of the sale date based on reasonable expectations regarding the initial public offering price. […] The issue price of bonds may not exceed their fair market value as of the sale date.”

The Government Finance Officer’s Association issued best practice guidelines in October 2010 for pricing on a negotiated sale to avoid problems. The Bond Buyer article referenced below states that the GFOA guidelines list eleven recommendations for confirming issue price, including communicating to the underwriter specific goals to be achieved in the pricing of bonds and expectations regarding the roles of each member of the financing team. The GFOA also urges issuers to take steps during the underwriter selection process and before final pricing to manage the compensation of underwriters.

Practical Definition of Issue Price:

This definition of issue price shown under the previous heading has the elements described below – an underwriter’s or purchaser’s certificate regarding issue price should reflect these elements:

For publicly offered bonds:

Actual sale: Issue price is the first price at which at least 10% is sold to the public. But see the reasonable expectations alternative.

Public: The public doesn’t include bond houses, brokers or similar persons or organizations acting in the capacity of underwriters or wholesalers.

Separate: Issue price of bonds that are not substantially identical is determined separately.

Reasonable Expectation: Issue price is determined as of the sale date based on reasonable expectations regarding the initial offering price. This means, the underwriter can either certify that at least 10% was actually sold or that the underwriter “reasonably expected” on the sale date that at least 10% would be sold at the issue price. Reasonable expectation is possible only if the bonds were offered at a bona fide public offering. Note that it may be easiest for the underwriter to certify that “all” bonds were actually offered in such bona fide public offering, but it would probably be okay if the underwriter states that at least 10% of each maturity and interest rate of the bonds was offered in the bona fide public offering. The Code and Regulations do not require that all 100% of each maturity and interest rate be actually publicly offerred as long as you can satisfy the 10% sale expectation. Obviously, if no bonds of a particular maturity and interest rate are offered, there cannot be an expectation to sell at least 10% of such maturity and rate! In other words, at least 10% of each maturity and interest rate must be offered.

Fair Market Value: There must be certification that the issue price of the bonds does not exceed the fair market value of the bonds. (Note, the reason for OID and OIP is to get a fixed rate bond to a fair market value when the face amount of the bond does not otherwise represent a fair market value.) Fair market value is defined in Treas. Reg. § 1.148-5(d)(6).

Example Certification: (1) As of __________ __, 20__ (the “Sale Date”), the Underwriter offered all of the Obligations to the general public (excluding bond houses, brokers or similar persons or organizations acting in the capacity of underwriters or wholesalers) in a bona fide public offering at the prices and yields that the Underwriter reasonably expected the principal amount of each maturity of the Obligations would be initially sold, as shown on Attachment 1 hereto. (2) Such offering prices and yields represented fair market prices and yields for the Obligations as of the Sale Date. (3) As of the date hereof [the issue date], at least 10% of each maturity and interest rate of the Obligations has been first sold at such prices and yields to the general public (excluding bond houses, brokers or similar persons or organizations acting in the capacity of underwriters or wholesalers) prior to the sale, allocation or allotment of any of the Obligations to any purchasers at prices and yields other than those set forth on Attachment 1 hereto. [Note: This certification may be a bit broad (a belt and suspenders certification), in that it uses the reasonable expectation certification, but then also has the underwriter make an actual issue date statement regarding the sale of the bonds. However, the statements taken together more broadly support the reasonableness of the issue price, while also providing a more exact issue price that does not rely on reasonable expectations. In other words, the problem of determining reasonableness is mitigated.]

For privately placed bonds: Technically, the same definition applies as for publicly offered bonds. But note the following practical differences:

Purchase Price: The issue price is simply the price at which the initial purchaser purchases the bonds. There is no bona fide public offering, so the expectation standard doesn’t apply, and there is no need to discuss the sale of a substantial amount since the entire bond issue is sold to the purchaser.

Fair Market Value: There must still be a certification that the issue price of the bonds does not exceed the fair market value. Purchasers may have a difficult time making this statement, since practically they haven’t necessarily surveyed the market. Instead, the sale took place based on an RFP process or arm’s-length negotiation (see Treas. Reg. § 1.148-5(d)(6) regarding arm’s-length negotiation to establish fair market value). The certification therefore should either explain that the issuer solicited proposals or at least that the price for the bonds was negotiated at arms’-length. This should satisfy the fair market value certification that bond counsel requires.

Example Certification: The Initial Purchaser purchased, on a direct placement basis, the Obligations on __________ __, 20__ (the “Sale Date”), pursuant to a Private Placement Agreement, dated the date hereof, among _______________ (the “County”), the Trustee and the Initial Purchaser, at the price of $_______________, being the aggregate principal amount of the Obligations. Such purchase price was derived through a solicitation by the County of proposals for the purchase of the Obligations.

EMMA Matters:

EMMA shows certain special condition indicators on its recent trades screen. The indicators show whether any special conditions apply to the trade. Most trades do not have special condition indicators. The categories of indicators are as follows:

(A) Assumed settlement date: The actual trade settlement date was unknown at the time of the trade. The settlement date is usually after the trade date.

(L) List offering price/takedown trade: Indicates a trade executed on the first day of trading of a new issue, either by an underwriter or another broker-dealer or bank involved in the initial distribution of the securities at the published list offering price for the security, or by an underwriter to another broker-dealer or bank involved in the initial distribution of the securities at a discount (or “takedown”) from the published list offering price for the security.

(P) Weighted average price trade: Indicates that a trade was reported using a weighted average price based on multiple transactions done at different prices earlier in the day to accumulate the total amount of bonds needed to make the transaction.

When Issued trade: Indicates that a trade in a new issue security was executed on or before the final issuance or settlement of the issue of securities by the issuer.

In the News:

“Treasury to Issue Regulations on Issue Price,” The Bond Buyer, March 9, 2012. “Lawyers should not have to look at prices on the MSRB’s online EMMA system to determine if munis were initially offered at prices that raise questions about tax-law compliance.”

“IRS Details How Issuers Can Check Bonds’ Issue Price,” The Bond Buyer, June 14, 2012. (Available here) “When IRS agents look at EMMA data, they look for instances where the bonds were not fully placed, there are upward pricing trends, or simultaneous trades showing less than 100% at the initial public offering and premium trades occurred subsequently. They also look for apparent dealer prioritization over the public and the dealers involved in the trades. […] The TEB’s focus in terms of scrutiny of issue price is primarily with negotiated sales and not competitive sales, according to Dodd. ‘It is our understanding that any of the pricing anomalies that we think we might observe will likely be in respect to negotiated deals,’ she said.”

Comment Regarding Competitive Sales Exception to the General Rule, National Association of Bond Lawyers, February 22, 2016. (Available here)

Issue Spotting:

If there are multiple maturities, how will the issue price need to be determined:

The issue price will need to be determined on a per-maturity basis. A substantial amount of bonds for each maturity must have been sold to know the issue price. A substantial amount is 10%.

What happens if the underwriter has not been able to sell a “substantial amount” of any particular maturity:

If a bona fide public offering was made, the issue price is determined as of the sale date based on “reasonable expectations regarding the initial public offering price.” Furthermore, the issue price does not change if part of the issue is later sold at a different price. This means, the issue price can be established either by proving up that a substantial amount of each maturity/interest rate has actually been sold, or at least stating what the reasonable expectations of such sale were by the underwriter on the sale date. See Treas. Reg. 1.148-1(b).

If the bonds are being privately placed, the issue price is the price at which they are purchased. There is no concept or need of sale of a “substantial amount.”

References:

See TD 9599 for final regulations regarding issue price for publicly traded property.

Document Drafting Matters

Ensure that the reimbursement agreement or letter of credit describes how the letter of credit may be cancelled, and what the process is when an optional redemption pursuant to the terms of the reimbursement agreement coincides with the date on which the letter of credit is cancelled. Should an optional redemption notice be provided or should the optional redemption be waived?

Other Matters

Payment of letter of credit fees might be considered capital expenditures, especially if paid during the project period. If the letter of credit fee is amortized beyond the project period, however, portions of the fee could be treated as working capital expenditures. Therefore, it may make sense to assume that the fee won’t be counted as a capital expenditure to test whether the 95/5 test is met.